speeches · March 23, 2009

Regional President Speech

Charles L. Evans · President
Oce of the President Money Museum Last Updated: 113009 Central Banking in Times of Crisis Czech National Bank Prague, Czech Republic Introduction Good morning and thank you for inviting me to participate in this important discussion We are in the midst of the worst nancial crisis of the past 70 years Extraordinary disruptions in the ow of credit and liquidity have weighed on the economies in the United States, Central and Eastern Europe, and around the world As events have unfolded over the past 20 months, the Federal Reserve, together with the United States Treasury and the Federal Deposit Insurance Corporation FDIC, has implemented a broad range of policies aimed at mitigating the problems in our nancial system and the fallout on the rest of the economy I believe that our interventions are helping to address the diculties we face and to eventually move the United States back to nancial stability and economic recovery And, as you are all well aware, capital ows are international So, these eorts should also be positive factors for nancial markets and economic activity around the world Today I will concentrate my remarks on the Fed's responses to the liquidity and credit shocks that have aected the US nancial system I will also discuss the challenges that lie ahead and our continued commitment to confront them I should note that these are, of course, my own views and not necessarily those of my colleagues in the Federal Reserve System Credit and liquidity shocks Trouble began in 2007, when falling housing prices and rising mortgage defaults produced strains in the market for securitized mortgages As a result, many nancial institutions reported severe losses Famous names such as Bear Stearns, Wachovia, Washington Mutual, Merrill Lynch, Lehman Brothers, and American International Group AIG, were on that list Some of these rms appeared unable to survive on their own and were purchased by other nancial institutions In the case of Bear Stearns, this involved assistance from the Federal Reserve The Federal Reserve and the Treasury also were able to arrange loans and guarantees to AIG in order to avoid large-scale disruptions in markets that had exposures to credit default swaps written by AIG In contrast, when Lehman Brothers experienced especially large losses, no sale or loan support could be made at suitable terms As a result, Lehman went into bankruptcy last September Lehman Brothers' bankruptcy intensied market participants' concerns over the potential losses on a range of assets, as well as over the ability of their counterparties to meet contractual obligations One important sector that was disrupted was the money market industry Worried over losses, investors in money market funds began making redemptions To meet these redemptions, some funds had to liquidate assets into an already depressed market, further lowering the prices of these instruments The disruptions in the money market industry were the product of two main shocks: a credit shock and a liquidity shock First, because of deteriorating economic conditions, market participants expected greater losses on commercial paper and other short-term securities This is what I refer to as a "credit shock" Second, the ease of trading these securities worsened: transaction volumes shrank dramatically, and in some cases it was even dicult to obtain price quotes This is what I call a "liquidity shock" The two shocks are not independent, as deteriorating liquidity conditions can spillover to produce higher losses among market participants The interplay between credit and liquidity shocks made it dicult for rms to issue all but the safest and most liquid commercial paper Only very short-term, often overnight, debt was issued when market conditions were at their worst It is easy to see the role that "ight to quality" played in these events And I would like to underscore that "ight to liquidity" alone was suciently severe to disrupt the functioning of some markets that were largely immune from credit shocks For example, in the United States many student loan payments are guaranteed by the federal government Despite these guarantees, liquidity disruptions have nearly shut down the auction rate securities markets that student loan providers had used to obtain a good deal of their funding Subsequently, they have had substantial diculty in attracting investors to other types of securities backed by student loans A second example is the market for Treasury Ination Protected Securities TIPS Like other Treasury securities, TIPS benet from the guarantee of the federal government Yet, in past months they have traded at a signicant discount relative to more liquid on-the-run nominal Treasuries Monetary policy in exceptional times The Federal Reserve has responded aggressively to these extraordinary events Since September 2007, the Federal Open Market Committee FOMC has lowered the target for the federal funds rate—our standard overnight interest rate policy lever— bringing it to essentially zero in December of last year In addition, we have made adjustments to make it more attractive for banks to borrow from the discount window However, nancial distress, the weak outlook for growth, and the prospects for unusually low ination call for more policy accommodation With the funds rate near zero, the Fed has had to work to nd new ways to inject monetary accommodation into the economy One way to make monetary policy more accommodating is to work to lower the unusual liquidity and risk premia that are raising private and longer-term borrowing costs In this arena, the Federal Reserve has adopted several innovative policies that are providing liquidity support to a range of institutions and markets Some of these policies were aimed at easing the liquidity pressures I spoke about earlier that hit the money market funds and commercial paper markets last fall Two important ones were the Money Market Investor Funding Facility or MMIF and the Commercial Paper Funding Facility CPFF Most recently, a new joint program with the Treasury, called the Term Asset-Backed Securities Loan Facility, or TALF, became eective on March 19 The rst lending through this temporary facility is designed to make credit available to consumers and small businesses on more favorable terms by facilitating the issuance of new asset-backed securities ABS and improving the market conditions for ABS more generally The TALF is providing nancing to investors to support their purchases of certain highly-rated ABS backed by newly and recently originated auto loans, credit card loans, student loans, and small business loans guaranteed by the Small Business Administration Purchasers of these ABS will be able to borrow from the TALF, using the securities themselves as collateral The ABS market has typically played a critical role in providing credit to US consumers and small businesses However, this market has virtually closed since the worsening of the nancial crisis last October The TALF is aimed at re-opening this market by helping lenders nance new issues Moreover, the program provides a lending backstop that will enhance the liquidity value of TALF-eligible securities Since the announcement of the TALF, liquidity conditions in these securities have already improved It is important to note that the TALF loans are for three years—medium-term loans that are noticeably longer than those available through other Fed lending facilities So, TALF can impact longer-run interest rates Another important feature of the TALF is that the terms on these loans are attractive during current market conditions but are more costly than those that prevail during more normal times So, TALF loans will become unattractive when conditions improve in markets for traditional sources of funding Appropriate haircuts on the collateral and funding from the Treasury provide the Fed with credit protection on the facility I should also note that, as conditions warrant, we will be expanding existing programs For instance, the Fed already is undertaking a substantial expansion of the TALF Last Thursday we added four new categories to the list of TALF-eligible ABS And yesterday an expansion of the TALF to legacy assets was announced, with the new assets expected to include non-agency residential and commercial mortgaged-backed securities Moreover, on March 18 the FOMC decided to further increase the size of the Federal Reserve's balance sheet by purchasing up to $115 trillion of additional securities, comprising up to $300 billion of longer-term Treasuries, up to $750 billion more of agency mortgage-backed securities, and up to $100 billion more of agency debt Prices of Treasuries jumped sharply after the FOMC announcement, with the ten-year yield falling nearly 50 basis points over the day Together with the Treasury and the FDIC, the Fed earlier had also taken exceptional measures to attenuate the eect of the credit shock For example, we provided assistance to JPMorgan Chase in the acquisition of Bear Stearns, and we arranged the ring-fencing of some non-performing assets held by Citi and Bank of America Moreover, we provided capital to support the purchase of some collateralized debt obligations and the unwinding of AIG's credit default swap positions Additional interventions to deal with the credit crisis are being implemented For instance, there is the Treasury's Financial Stability Plan The plan includes a Capital Assistance Program to strengthen US nancial institutions so that they have sucient lending capacity to better support economic recovery The plan also includes a Public-Private Investment Program, aimed at providing greater means for nancial institutions to cleanse their balance sheets of what are often referred to as "legacy" assets Many of the details of this program were released yesterday, including the expansion of the Fed's TALF to legacy assets that I just mentioned When economic activity recovers and nancial conditions normalize, the use of nontraditional policy tools and the size of the Fed's balance sheet will be reduced, and the FOMC will return to its traditional focus on the federal funds rate Some of this wind-down process will occur naturally as market conditions improve, given the particular pricing and maturity design features of these programs Still, nancial market participants need to be prepared for the eventual dismantling of the facilities that have been put in place during the nancial turmoil Fortunately, it is most likely that this dismantling would be associated with better economic and nancial performance Conceptual motivations for these new initiatives Let me briey step back and discuss these programs at a more conceptual level In a well-functioning nancial system, arbitrage moves funds across markets and balances out prot opportunities It thus aligns term and risk-adjusted returns across markets This is the reason, for example, why our typical moves to lower the short-term risk-free federal funds rate aect borrowing rates over a large range of maturity and risk structures When nancial markets are functioning well, the Fed can focus on the size of the liquidity injection instead of the particular segment of the market in which the injection occurs But that is not the case today There is abundant evidence that arbitrage opportunities remain unexploited Because of balance- sheet capacity limitations, or because of higher-than-normal uncertainty and risk aversion, market participants are largely avoiding markets that are undergoing unusual stress For instance, as I mentioned previously, liquidity disruptions have made it dicult to attract investors to several types of securities backed by student loans, even in the presence of a federal government guarantee One way of thinking about these developments is that markets have become highly segmented We do not see funds owing in to take advantage of apparent prot opportunities with respect to distressed assets If they were, they could ease liquidity pressures in these sectors and help keep some problems from spilling over into solvency concerns The ip side of this market segmentation is that liquidity injections aimed directly at a particular distressed market are less likely to leak out to other areas The injections thus can signicantly improve that market's functioning, seeding its transition to more normal liquidity and risk valuations This is the rationale for focusing our nontraditional policies on loans and securities that aect transactions in particular key markets where we see points of stress But a downside is that markets that are not the particular focus of policy intervention could experience some relative disadvantage because of the segmentation As stressed markets improve, more normal functioning of the nancial system as a whole can be achieved Market participants will become more willing to carry on their usual arbitrage activities, and segmentation will diminish This will diminish both the need and usage of the special programs we have created Because segmentation will change dynamically, the eectiveness and unintended consequences of credit policies can shift over time and in unexpected ways This highlights the need for careful design and continuous monitoring of these programs The programs I discussed today will help improve credit and liquidity conditions in US nancial markets Since capital ows are international, these initiatives have the potential to positively impact capital markets around the world as well The Federal Reserve has also worked together with other countries to address pressures in global money markets directly For instance, the Fed has established temporary reciprocal currency arrangements swap lines with several nations' central banks These facilities are designed to help improve liquidity conditions in global nancial markets and to make it easier to obtain US dollar funding Other international eorts are in place to provide direct support to countries that have been particularly aected by the nancial crisis For instance, the International Monetary Fund IMF has provided funds to several Central and Eastern European countries, including Latvia, Hungary, Ukraine, and Belarus; and Romania is in talks with the IMF Moreover, the European Bank for Reconstruction and Development EBRD, the European Investment Bank EIB Group, and the World Bank Group recently pledged to provide up to €245 billion to support the banking sectors in Central and Eastern Europe and to fund lending to businesses hit by the global economic crisis Conclusions Modern economic theories usually imply that there is little the public sector can do to oset a cyclical contraction in technology except to oset, to some degree, rigidities that aect the economy's response to the shock This logic would carry over to nancial shocks as well, if we chose to model them as a negative cost shock to an intermediate input However, there are reasons to believe that policy has a very dierent role to play in mitigating the impact of nancial shocks For one thing, the Fed and other nancial regulators are themselves part of the nancial intermediation process This means there could be alternative policy instruments that might directly aect the way the economy responds to a nancial shock Since August 2007, the FOMC's policy decisions have been calibrated to deal with the "adverse feedback loop" between disruptions to nancial market stability and the real economy This focus has inuenced not only the setting of the funds rate, but also the implementation of several new policies aimed directly at the nancial shocks, some of which I have discussed today I believe these initiatives will help in restoring the normal functioning of the nancial system They will also have a stabilizing eect on markets around the world and will therefore eventually help stimulate worldwide economic recovery Note: Opinions expressed in this article are those of Charles L Evans and do not necessarily reect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System
Cite this document
APA
Charles L. Evans (2009, March 23). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20090324_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20090324_charles_l_evans,
  author = {Charles L. Evans},
  title = {Regional President Speech},
  year = {2009},
  month = {Mar},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20090324_charles_l_evans},
  note = {Retrieved via When the Fed Speaks corpus}
}